Lease accounting is an essential accounting subject since it varies based on the end-user. A lessee and a lessor manage and account for leases in various ways. The asset holder is the lessor, and the lessee utilizes the leased premises by paying the lessor regularly.
In this article, we’ll explain everything you need to know about lease accounting and why it’s an important subject worth getting yourself familiar with.
What Is Lease?
A lease is a legal contract in which the owner of a certain asset (lessor) authorizes a third party (lessee) to use the object for a fixed length of time in consideration of regular payments to the lessor.
An operational lease allows the lessee to utilize the financial premises for a defined length of time, usually less than the asset’s useful life. A financing lease is quite similar to borrowing money to buy an asset.
Both IFRS and US GAAP use different criteria to determine whether a lease is a financing or an operational lease:
A financial lease is one in which the lessee is eligible for all of the risks and benefits associated with ownership.
A lease is classified as a finance lease if it fits any one of the four criteria listed below:
- If, at the end of the lease, the lessee becomes the owner of the leased asset.
- The lease permits the lessee to acquire the identical leased item at a future date for a price less than the asset’s fair value.
- The lease term is 75% or more of the useful life of the leased item.
- If the current value of the finance lease equals or exceeds 90% of the asset’s fair market value.
Lessee Accounting And Reporting
Accounting and financial reporting requirements for various leases are as follows:
- Lessee Accounting For Finance Lease. Both leased goods and lease payments (liability) are recorded on the balance sheet. Statement of cash flows and the interest element of the lease payment is recorded as an operational cash outflow under US GAAP.
- Lessee Accounting For Operating Lease. There is no asset or liabilities recorded on the balance sheet. The asset’s rent is expensed and is the same as the lease payment. As well as the whole lease payment or rent expenditure is represented as an operational cash outflow.
The Effect Of Lease Accounting On The Financial Statements Of The Lessee
The distinction in accounting in both leases, finance, and operational, has an influence on the following financial statement elements:
- A finance lease has more investments, liabilities, net earnings in later years, operational income (EBIT), and operating cash flows than an operating lease.
- A finance lease has a lower initial net income and cash flow from finance than an operational lease.
- Revenue and total cash flow are the same in both contracts.
The Effect Of Lease Accounting On Financial Ratios of Lessees
Financial ratios are influenced by the many leases:
- The financing lease has a reduced current ratio, working capital, asset turnover, fixed return on assets, return on assets in early years, and return on equity in early years.
- The finance lease has a greater return on assets, return on equity, debt to assets ratio, and debt-equity ratio in later years.
Accounting and Reporting by Lessor
Accounting For Finance Lease By Lessor
Under US GAAP, there are two types of financing leases for the lessor. It is computed on the lease receivable at the start using the lease interest rate.
- Cash Flow Statement. The leasing revenue’s interest component is recorded as an operating cash inflow, while the payment’s principal component is reported as an investment cash inflow.
- Lessor Accounting for Operating Lease. The lessor reports the operating lease on various financial statements.
- Balance Sheet. As usual, the leased asset is reported.
- Income Statement. The income revenue is disclosed, as well as the asset depreciation.
The Effect Of Lease Accounting On The Financial Statements Of The Lessor
The lessor’s financial statements are influenced by the variance in both leases in the following ways:
- Both leases have similar leasing revenue and overall cash flow.
- The financing lease generates more income in the early years than the operational lease.
- The income in the later years of a financing lease is smaller than that of an operational lease.
- A finance lease has a lower operating cash flow than an operating lease.
- Taxes are greater in the early years of a financing lease than in an operating lease.
A lessee’s accounting and reporting requirements differ from those of a lessor. It also varies depending on whether the lease is financial or operational. As a result, it is critical that the lease be properly classified and recorded since it has significant consequences for financial statements and financial ratios.